If you’re the owner or merchandiser of a retail or pawn shop business, you know it’s important to keep track of inventory turnover. Between overstocks, managing your warehouse, and keeping up with seasonal inventory, it can be difficult to stay on top of it all. However the secret to meeting your current inventory needs and determining what they will be in the future is understanding your inventory turnover ratio.
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What Is Inventory Turnover?
Inventory turnover, also known as stock turn or inventory turns, is a ratio that refers to the number of times a stock of inventory was sold in a given period. The faster you sell your inventory, the higher your inventory turnover. Store owners and merchandisers use the inventory turnover ratio to make inventory purchase decisions.
Calculating your inventory turnover ratio is the key to determining whether or not you’re ordering too much—or too little—of a product. Order too much, and you may lose money when you are unable to move it. Order too little, and you may leave your customers disappointed and seeking out your competitors.
Related: What Is a Good Inventory Turnover Ratio?
How to Calculate Inventory Turnover
Calculating your inventory turnover ratio isn’t difficult once you know how to do it. Follow these steps to calculate this ratio:
- Take a look at your annual income statement and determine the total cost of the goods you sold.
- Add together your beginning and ending inventory numbers in any month from that year, then divide that figure in half. What you’re left with is the average cost of your inventory.
- Use that figure to divide the cost of your total goods sold.
The costs of your goods sold are also often known as COGS.
For simplicity’s sake, let’s take a look at a hypothetical retailer with a low annual COGS of just $10,000. If they sold that amount over the course of a year, and they had annual sales of $100,000, this means they’ve had to order new inventory 10 times, resulting in a ratio of 10.
By following these steps, you’ll have the number of goods you sold vs. how much you spent to acquire it and how quickly you sold it. You can use this figure to determine whether or not you have the right amount of inventory and to see how you stand up against competing businesses.
What Is a Good Inventory Turnover Ratio?
A good inventory turnover ratio for one industry won’t look the same for another, because this figure is industry-specific and can vary significantly. In other words, you can’t judge your inventory ratio based upon the ratio of a business that isn’t similar to your own.
Although grocery stores and fashion boutiques are both retailers, these two industries have average inventory turnover ratios that are very different. A car dealership might be impressed by a turnover ratio of five, because the industry average is four to six. However, a grocery store would be unhappy with a 5, because the average for that industry is 14.
If you have a low-margin business in which you offer discounts on goods and lower profit margins in exchange for a higher volume of sales, your ratio will have higher turnover rates. If you have a high-margin business in which each item costs more and results in greater profits per sale, expect a lower ratio.
What Is an Ideal Inventory Ratio for Retail?
Again, the ideal ratio for retailers will depend on what you sell. The reason grocery stores enjoy such a high ratio is their products have a short shelf-life. If they don’t move them quickly, they’ll lose the profits. However, if you are a retailer of products like high-end, timeless furniture that requires craftsmanship and patience for those who are willing to pay for it, your ideal will be a much lower ratio.
As far as retailers are concerned, in general, an acceptable average is considered by most to be between six and 12.
What Does an Increase in Inventory Turnover Mean?
An increase in inventory turnover could be directly related to timing. If you’ve offered a special promotion or you’ve introduced a new product, your ratio may change suddenly and drastically.
Another reason for a high turnover rate could be that you don’t have enough inventory. If your customers are buying your inventory up quickly, it may be due to the law of scarcity. They’re stocking up before you run out. This may work if you’re the only retailer in town that offers an item, but if you’ve got competitors it may also backfire.
What Does a Decrease in Inventory Turnover Mean?
If you’ve experienced a sudden decrease in your turnover ratio or a slow decline over time, there are several potential culprits. Your marketing efforts may not be all they can be. If you’re not paying attention to your competitors and staying one step ahead, you may be losing sales. In the process, you’ll be stuck with the inventory you purchased based upon your previous higher ratio, which is now a thing of the past.
You could also be experiencing a decreased ratio because you’ve overstocked. If you buy too much you run the risk of the product becoming obsolete before you can unload your inventory. When you’re ordering inventory, keep in mind that you’ll also need to pay to warehouse any items you can’t move, adding to the overall cost of each unit.
Determining your inventory ratio will allow you to understand annual and seasonal patterns in your inventory so you can make decisions that will be right for your business going forward. As a merchandiser or retail business owner, you need to know your store's inventory ratio. You’ll also know what volumes potential suppliers for your store should be able to handle to keep it stocked.
